Insurance Company Pays Up, Resolving Unallocated Settlement and Defense Costs

This post was written by John Ellison and Luke Debevec.

On August 13, 2009, the City of Sterling Heights, Michigan received a check from United National Insurance Company for over $15.4 million, satisfying a judgment awarded by the federal district court for the Eastern District of Michigan and upheld on appeal by the Court of Appeals for the Sixth Circuit Apart from this payment, United National and Sterling Heights will continue to litigate the amount of additional damages that the Sixth Circuit determined to be due to the City.


In 2003, after several years of litigation, the City settled for $31 million various civil rights and defamation claims brought against it by Hillside Productions, Inc., the owners and operators of the Freedom Hill Amphitheatre located in Sterling Heights. Since then, the City sought to recover this payment, as well as the costs of defending the Hillside claims, from its various insurance companies. Once the Sterling Heights’ litigation with Hillside ended, it found itself in a new lawsuit with its insurance companies, none of whom wanted to pay for the Hillside litigation. In 2005 and 2006, two of the City’s insurers settled with the City for $18.75 million, leaving only United National. 

Throughout its dispute with the City, United National had contended that it was only responsible for defamation-related allegations, which the insurer argued represented only a small fraction of the total value of the City’s global settlement with Hillside. In addition to defamation, that settlement had also resolved numerous claims that the trial court determined were not covered by United National’s insurance policies, such as violations of Hillside’s civil rights. In 2006, the trial court ruled that at least one-third of the total value of the City’s settlement, defense costs, and consequential damages should be United National’s responsibility, using a pro rata time-on-the-risk formula, given that it was one of three insurance companies that provided insurance for claims that had been settled. In 2007, the City was awarded a judgment against United National that was worth in excess of $14.6 million. 

United National appealed the City’s judgment, arguing among other things that the defamation-related claims could not reasonably represent one-third of the City’s settlement with Hillside. United National protested that allocation was not appropriate to resolving an insurer’s liability for an unallocated global settlement of several types of covered and uncovered claims. On March 31, 2009, the Sixth Circuit ruled handing a complete victory for Sterling Heights. The Sixth Circuit held that the one-third allocation was an appropriate means of estimating those damages relating to covered defamation allegations. The Court accepted the City’s arguments that pro rata allocation was “fair” due to the indivisibility of harm alleged by the underlying plaintiffs flowing from both uncovered and covered causes of action, the failure of the insurance company to participate meaningfully in the settlement process, as well as the “impossibility” of requiring the City to prove the value of its covered causes of action after the fact. 

The City will now pursue an additional $875,000 in damages because the appeals court also accepted the City’s arguments that the trial court significantly undervalued the City’s consequential damages. The Court of Appeals agreed with the City that it should be entitled to consequential damages from the date United National breached its insurance policy, not the later date originally selected by the district court.

Third Circuit Misses the Mark in CPB International

This post was written by Douglas R. Widin.

Recently, the Court of Appeals for the Third Circuit decided Nationwide Mutual Insurance v. CPB International, Docket No. 07-4772 (April 14, 2009). CPB supplied chondroitin to Rexall for use in compounding tablets, including chondroitin and glucosamine. CPB supplied two batches of chondroitin that turned out to fall short of contractual specifications and to contain impurities. By the time these defects were discovered, Rexall had already compounded the CPB-supplied material with glucosamine, so that both compounds had become useless.

In the lawsuit that ensued, Rexall brought a claim for breach of contract against CPB seeking return of the purchase price it had paid for the first batch, and also seeking consequential damages for the damage to the glucosamine and economic losses. CPB tendered that claim to its CGL carrier, Nationwide, which defended under a reservation of rights and also brought a declaratory judgment action to avoid any duty to defend or indemnify.

The Third Circuit held in favor of Nationwide and discharged it from any coverage obligations.

The court first observed that the matter clearly involved a claim of property damage, so it didn’t focus on that issue. It then examined the claim made by Rexall against CPB and concluded it was solely based on breach of contract. Turning to the crux of the coverage issues, the Third Circuit, premised on the Pennsylvania Supreme Court's decision in the Kvaerner case [Kvaerner Metals Div. of Kvaerner US, Inc. v. Commercial Union Ins., 908 A.2d 888 (PA 2006) determined that the simple allegation of delivery by CPB of defective chondroitin was an allegation of faulty workmanship that is not covered by the CGL policy. The Third Circuit went further than Kvaerner, however, deciding that, since faulty workmanship is not sufficiently fortuitous to be an accident or an occurrence, the consequential damages flowing from the faulty workmanship, being the foreseeable consequences of that faulty workmanship, are also not an accident or an occurrence. Therefore, the court held that the consequential damages were also not covered. In conclusion, the Third Circuit wrote, "We are, therefore, confident that the Supreme Court of Pennsylvania would conclude that an underlying claim alleging breach of contract would not trigger coverage under a CGL policy."

Adding insult to injury, the court held as an alternative ground for denial of the claim that the contractual liability-exclusion of the policy applied. The policy at issue contained a standard contractual liability-exclusion stating that the "insurance does not apply to … ‘property damage’ for which the insured is obligated to pay by reason of the assumption of liability in a contract or agreement." We have all seen this exclusion in various forms many times. We all recognize that it is designed, as is often stated expressly, to apply to a situation where the insured assumes the tort liability of another in a contract, such as by giving an indemnity. The Third Circuit did not consider this reading of the exclusion at all. This leads to the most disturbing element of this case, which is that the court did not even consider the potential alternative reading of this exclusion, such that it is interpreted as only applying to assumption of a third party's liability. Instead, the court effectively turned the normal rules of insurance policy construction—ambiguities are construed against the insurer as drafter—on their head and gave the insurer the benefit of an inherently ambiguous policy provision.

Although the Third Circuit's decision is unquestionably flawed, denials of coverage by insurance companies for consequential damages based on this case can be anticipated. Policyholders faced with this should point out to their carriers that the CPB case is limited to purely contract-based claims, so any suit involving a tort claim should be analyzed differently. 

Even more disturbing, the CPB case may well be invoked by first-party insurers by applying and interpreting faulty workmanship exclusions in a much broader sense in first-party claims. Finally, carriers will likely be pushing the limits of their contractual liability exclusions, even when based on more traditional phrasings than the one found in CPB, to try to preclude claims wherever there is a contract involved that forms any basis of the allegations of liability on the part of the insured. It is hoped that in the not too distant future, a case will come up in the Pennsylvania state court system that will provide the Pennsylvania Supreme Court with the chance to correct some of the Third Circuit's mistakes. Until then, however, policyholders will need to contend with the unfortunate and flawed decision in CPB.